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Everything You Need to Know About Value-Based Pricing

One of the most difficult decisions for any business owner – professional service or otherwise – is how best to effectively price his or her product or service. And with good reason, too.

Price too low and risk undermining the brand or leaving money on the table. Price too high and chance alienating a profitable market segment.

Not to dismay, because we’ve compiled a list of its top 5 steps for a successful strategy by giving you everything you need to know about value-based pricing.

1. Price based upon your value, not your cost.

The first step is to realize that the value delivered to clients is not the same as the cost incurred or the hours worked. Sound pricing models don’t start with statements like, “well it takes me 3 hours to do this kind of tax return, so the price should be…”

Consumers don’t walk into supermarkets with consideration for how long the farmer spent harvesting the corn they’re about to buy. They don’t make careful decisions of laundry detergent based on the hours of R&D and volume of intellectual property the manufacturer logged. And they most certainly don’t ask for a timesheet from the butcher behind the meat counter before asking him to hand over their perfectly carved filet.

None of that matters. They’ve decided what they’re willing to pay for corn, detergent, and steak, and regardless of what it took to produce those items, that’s all they’re going to pay. Like it or not, that’s how clients think about the services they receive too.

As ridiculous as those examples sound, it’s exactly how we used to think about pricing.

“If among a nation of hunters … it usually costs twice the labour to kill a beaver which it costs to kill a deer, one beaver should naturally exchange for or be worth two deer.”

If Adam were going to re-write the Wealth of Nations today, it’s just as likely that he’d say something like this:

“If among a nation of consumers….it usually costs twice the labour to mine salt which it does to mine a diamond, one gram of salt should naturally exchange for or be worth one gram of diamond.” (Which, if you’re doing the conversion, is five carats).

For all of the things Adam Smith got right in the Wealth of Nations, his theory of price wasn’t one of them. Fortunately, a new way of thinking called Marginalism emerged in the 1870s, which flipped the traditional Labor Theory of Value on its head.

And what does Marginalism have to say about pricing? Ron Baker offers the most succinct explanation I’ve found, which is:

“The costs do not determine the price, let alone the value. It is precisely the opposite; that is, the price determines the costs that can be profitably invested in to make a product desirable for the customer, at an acceptable profit for the seller.”

In other words, the price is dictated by what the consumer is willing to pay. Period. And the costs to provide that good or service dictate how much or even whether the supplier provides them.

In accounting, we commonly refer to this concept as “value pricing,” but in the real world, we just call this a “market rate.”

You probably haven’t read a single article on pricing in the last year that didn’t mention value pricing – it’s become the rage in accounting and many professional services. The reality is value pricing isn’t new or novel; it’s just an alignment to the way mainstream economics has thought about pricing for the last 140 years.

2. All services are not created equal

At its core, value pricing asserts that price is a subjective, not objective, measure of value. Your price should reflect what your customer is willing to pay – or said differently, the benefit they perceive. But, do all customers perceive value the same way?

Depending on your industry, the answer is probably “no.”

Airline tickets fluctuate wildly depending on time of day, time of year, capacity of the airplane, and proximity to the travel date. Movie theaters charge different prices depending on the time of day and age of the ticket holder. And bars even occasionally charge different prices based on gender – ladies night, anyone?

These are not examples of companies maliciously extorting their consumers – they are companies that recognize different types of customers value their product or service differently. A daytime business traveler demands an airline ticket differently from a weekend vacationer. A moviegoer catching an afternoon show in the middle of the week often behaves differently from one on a Friday night date.

So, how do you know if you should charge different prices for similar services? Well, there are a few questions you should answer first:

1. Am I servicing different, identifiable markets?

2. Do those markets have different price elasticities. (In other words, are they more or less price sensitive)?

3. Can I keep the two groups separate?

For example, are individuals shopping for US tax services on April 1st as price sensitive as those shopping for services on January 1st? Probably not.

Do businesses subject to annual audits value precise GAAP financial statements in the same way that small, sole proprietorships do? Probably not.

If your business can answer each of the previous questions with “yes,” then you should strongly consider if and how to segment your market segments and price accordingly.

3. Don’t underprice yourself.

For a firm struggling with pricing, particularly a brand new firm, the initial reaction is often to underprice services. The typical thinking goes like this – “I’ll price myself low to start and make it easier to sell in the beginning, and then when I have the client experience to command a higher rate, I’ll raise my prices.”

Wrong. Don’t do it. And here’s scientific proof that you’re making it harder, not easier, to sell your services to your target client:

In behavioral economics, there’s a concept called Irrational Value Assessment. And it effectively states that consumers assign value to a product or service not by a rational or objective deduction of its true value, but rather by a completely irrational assessment based on how the product or service is framed in the moment.

Take for instance this experiment conducted by the Stanford Graduate School of Business. Members of the Stanford Wine Club were asked to participate in a ‘blind’ taste test of 5 wines, each with varying prices, and were asked to rate each wine. The twist, however, was that the experimenters didn’t provide 5 different types of wine – in many cases, they served the same wine multiples times with a different price.

The result? Participants consistently rated the wine with the higher price tag more favorably than the wine with the lower price tag – even though they were from the exact same bottle.

4. Provide your customers with options…

When pricing services for your firm, consider providing a small array of options from which your client may choose. Why? It’s all about framing.

Consider an experiment with the Economist documented by behavioral economist Dan Ariely. To a series of experiment participants, the Economist offered two subscription packages:

Online only access to the publication for 12 months: $56 Online and print access for 12 months: $125 When asked to select between the two options, the participants overwhelmingly selected the cheaper option.

Next, the experimenters added a third alternative – a decoy:

Online only for 12 months: $56 Print only for 12 months: $125 (DECOY) Online and print for 12 months: $125 When a new set of participants were asked to select among the three options, something really interesting happened. No one selected the print only option and the resounding majority selected the third, more expensive option!

By adding a third option that no one wanted, the experimenters were able to compel participants to purchase the more expensive option simply by framing it as a better deal.

5. …but don’t provide too many options.

If a business provides its customers with too many options, they run the risk of paralyzing the customer with indecision.

Take for instance an experiment run by Sheena Iyengar, a professor of business at Columbia University. In a California grocery store, experimenters set up a display to sell a particular brand of jam. Periodically, they cycled between a display with 24 varieties of jam and one with 6 varieties of jam.

What they found was that while shoppers were more drawn to the large display (60% of passers by stopped at the large display vs. 40% at the small display), they were significantly more likely to purchase after having sampled from the small display.

30% of shoppers that stopped to sample from the display with 6 jam varieties made a jam purchase, while only 3% purchased after sampling from the display with 24 varieties!

Putting it into practice

While we’ve found these steps and thinking were helpful for us in our own service business, implementing each will look differently for each business.

If nothing else, the most important first step is to understand why your customers buy your product or service and what value (monetary or otherwise) they’re getting from it. If you have to ask, ask. They’ll tell you.

And when you’ve figured it out, have the courage to ask for what you’re worth (to them).

If you’ve found other pricing strategies effective in your business, tell us about them. We’d love to hear!

The rate of job losses as a result of the economic downturn has slowed down, with the number of Australians out of work suppressed to under a million, according to new figures from the Australian Bureau of Statistics.